Written by Mary Ellen Biery, Research Specialist, Sageworks Inc.
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Privately held companies in the US are generating average annual sales growth of around 6 percent, with profit margins on average are at a five year high, and the US economy continues to post positive – if small – gains.
Recent surveys show that a sizable portion of private companies are worried that a potential lack of demand is the top barrier to growth. Business owners must protect themselves against financial and operational risks, even as they balance the need to service customers and plan for growth.
Sageworks Senior Financial Analyst Michael Lubansky says most companies at some point could find it useful to understand another company’s probability of default. A common situation where businesses desire more information on credit risk is when they are evaluating a new vendor or supplier. Evaluating the default risk before entering a contract can boost business safety by perhaps avoiding supply-chain interruptions.
Here are four types of businesses on which you should conduct financial due diligence:
“If you’re depending on a company to provide the supplies you need for your business operations, and if the supplier is not financially sound, you potentially expose yourself to problems that may slow your own business operations,” according to Lubansky. This could result in a shortage of raw materials or inventory, making it difficult to supply your customers.
DePaul University Professor of Finance Rebel Cole adds that in addition to affecting your ability to generate revenue, a supplier going out of business can also affect your cash needs. “They may be offering you trade credit and therefore you could be losing one of your sources of financing,” he says.
Vendors or distributors of your own products can potentially create business risk on several fronts that warrant vendor credit checks. “There’s reputational risk if a vendor or someone who is selling your product is not financially sound,” Lubansky says. “That could reflect poorly on you as a business operation.”
Additionally, if a vendor defaults you may have to identify another vendor so that your products can continue to be sold and distributed. This risk can lead to both lost revenue and sales channels.
Some businesses may find it helpful to run a business credit report for a major customer, too. “If your customer goes out of business that could be very problematic,” Cole says. “First of all, you lose sales, but more importantly, you may have accounts receivable outstanding. They may not be able to pay you back.”
“It doesn’t really matter which side of the supply chain they’re on – whether they’re a customer or a supplier. If they go under, they directly impact your ability to supply your goods and services and make money,” Cole says.
When a company is evaluating its own financial health and planning for growth or for weathering a downturn, an assessment of your current situation and probability of default helps create a more complete picture.
The same is true for a company that is considering applying for a loan. Knowing your own business credit rating prepares you for potential objections on the part of a lender and can build credibility as you negotiate on rates and fees. Lower rates and fees mean higher profits for you.
When banks assess potential borrowers, they are fundamentally examining the ability of a potential borrower to repay the loan. Analysing the potential borrower’s assets, as well as the cash-flow outlook and potential pitfalls are primary objectives.
Companies that have business credit ratings and understand their own default risk can also use that information in negotiations with other businesses. Similarly, deals involving mergers or asset purchases may be better informed with information on how likely it is the counterparty will default within a year.
Some people might find it advantageous to evaluate a business’s probability of default not only before entering into a business relationship, but also periodically thereafter. Experts say that a company’s probability of default can vary by stages of the business cycle and by stages of an industry lifecycle.
Reassessing credit risk is also a good idea when there are signs a business partner has experienced a change in financing or is facing a hardship. For example, if a business partner’s suppliers are suddenly accepting cash only for deliveries, it may be a good time to reassess default risk in order to protect your ability to recover accounts receivable.